I keep hearing of investors who want to liquidate several residential holdings and avoid any capital gains by selling their primary residence then moving into another previously rented out home, which becomes primary, selling after 2 years and repeating the process until completly liquidated. They tell me they can completly avoid any gains tax using this stategy. One accountant I had told me no, I would still have to pay based on the profits after the basis was calculated. I got a new acountant and she told me that yes the tax code requires the tax be paid but that few pay because its not an enforced requirement. So is this one of those fabled loopholes that the rich have always jumped through? Because if it isn't then I may as well just sell all my holdings and pay the piper.( I want out because the mortgages are nearly paid and I've had enough of maintenace and tenants!)
And you will give the readers of this forum first tibs
by posting them here when you're ready to sell, right?
Section 121 says that the first $250K ($500K married filing jointly) of gain is TAX FREE if it's been your principle residence for 24 of the previous 60 months. However, any gain attributable to depreciation is TAXABLE.
I guess it depends on (1) the amount of gain, I live in TX and we pretty weak housing appreciation, (2) the hassle factor attributable to moving and (3) how much of a step down is it to go from your current (rich landlord) home to move into one of the slums that are your rentals, LOL.
If the mortgages are nearly paid you're reaching the point where the cash flow gets really schweeeeeet! I had retired all of my mortgages early and was living off my rental income. A few years later I wanted to move a couple of hundred miles away and refused to deal with management companies.
Although I had all good houses in good neighborhoods I didn't want to spend any part of my retirement driving back and painting, roofing etc so I sold out. But what I did was offer "owner will finance with $2K down" deals. That got me lots of buyers and allowed me to get about 15% over market price, over market interest and spread my gain over several years.
But did you pay 25% taxes on the amount of recaptured depreciation when you sold? It's alot of money. Also, I understand that even if you have a rental you never set up on depreciationk, and live in for two years, you still owe tax that would have been due should you have set it up on depreciation.
They seem to have you coming and going.
There are three (3) scenarios possible here, and the answer varies slightly for each.
Rental Property to Primary Residence
An investor acquires rental property and rents it out for any length of time (it was not acquired as part of a 1031 exchange). The investor could sell and complete a 1031 exchange into another rental property, or the investor could move into the property, convert it to his/her primary residence, live in it for 24 months (minimum) and then sell and take advantage of the 121 exclusion pursuant to Section 121 of the Internal Revenue Code. The 121 exclusion is the $250/$500K tax-free exclusion available on the sale of a primary residence. This strategy would only exclude any capital gain up to the $250/$500K limitation and any depreciation recapture would be recognized.
1031 Exchange into Rental Property and then to Primary Residence
An investor owns rental property that he/she sells and 1031 exchanges into other rental property and after renting the newly acquired rental property for 12 to 18 months (in order to demonstate intent to hold for investment) converts it to his/her primary residence by moving into it and lives in it for 24 months (minimum, in order to satisfy the 121 exclusion requirements of living in it as a primary residence for 24 months out of the last 60 months).
This transaction is identical to the first one with the exception that it started off as part of a 1031 exchange, and because the property that was converted to his/her primary residence was originally acquired as replacement property in a prior 1031 exchange the investor must own it for at least five (5) years before he/she can sell and take advantage of the 121 exclusion. The five (5) year ownership (holding) requirement is a new requirement contained in the October 2004 income tax act.
So, to summarize, under this structure the investor would sell and exchange into new rental property, rent for 12 to 18 months, convert it to his/her primary residence, live in it for at least 24 months, and once he/she has owned it for a total of five (5) years he/she could sell the property and take advantage of the 121 exclusion. This strategy would also only exclude any capital gain up to the $250/$500K limitation and any depreciation recapture would be recognized. If the property has a lot of built up depreciation this strategy may not be appropriate for the investor.
Primary Residence to Rental Property
This is perhaps the best yet. The IRS issued Revenue Procedure 2005-14 that allows an investor to convert his/her primary residence into investment property and ultimately take advantage of both the 121 tax-free exclusion up to the limits of $250K/$500K AND defer the rest of their capital gain by using a 1031 exchange.
The steps would be to move out of the primary residence and rent it out for 12 to 18 months in order to demonstrate intent to hold for investment and then sell the property. As long as the investor has owned and lived in the property as his/her primary residence for at least 24 months out of the last 60 months he/she will qualify for the 121 exclusion. And, as long as the property has been held as investment property for a period long enough to demonstrate intent to hold and is investment property at the date of sale the investor can complete a 1031 exchange and defer the balance of his/her capital gain income tax liabilities.
Whew! Does any of that make sense?
Yes! And THANK YOU for the very detailed analysis of the three options. I hadn't known about those little changes that mean so much to the tax man. Thank you! :superman: